Michael Gray, CPA’s Option Alert #154
An irregular alert for issues relating to employee stock options
March 19, 2017
© 2017 by Michael Gray, CPA
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Table of Contents
- Extension season has started
- The Section 83(b) election and incentive stock options
- April 18 will soon be here!
- Please share your good experiences with Michael Gray, CPA
- Financial Insider Weekly broadcast schedule
- Follow me on social media!
- Check out my blog
- Interested in our other newsletters?
- Consult with a tax advisor
Extension season has started
We start planning on extensions for information received after March 15 for tax preparation. To make arrangements, call Dawn Siemer on Mondays, Wednesdays or Fridays at 408-918-3162
The Section 83(b) election and incentive stock options
Stock acquired by exercising an incentive stock option (ISO) has quite different treatment under the regular tax and the alternative minimum tax (AMT). The different treatment can have quite surprising results and can be viewed as a tax trap.
Under Internal Revenue Code Section 56(b)(3), the regular tax rules for incentive stock options don’t apply for the alternative minimum tax. That means stock acquired by exercising an incentive stock option is taxed under the rules for nonqualified stock options.
Under Internal Revenue Code Section 83(a), ordinary income is generally recognized for the exercise of a non-qualified stock option on the later of the date the option is exercised or the date the stock is vested.
Under Internal Revenue Code Section 83(b), a taxpayer may elect within 30 days of exercising a nonqualified stock option to disregard the vesting date (and other restrictions) and report the income from exercising the option on the date of exercise.
Under Internal Revenue Code Sections 422(a) and 421(a), no income is reported (for the regular tax) when an incentive stock option is exercised. If the stock is held more than two years after the grant date and more than one year after the exercise date, all of the gain is taxed as long-term capital gain. If the holding period requirements aren’t met, there is a disqualified disposition and the excess of the fair market value of the stock over the option price is taxed as ordinary income.
Under Internal Revenue Code Section 422(c)(2), if the stock is sold during the year of exercise, the ordinary income from the disqualified disposition is limited to the excess of the amount realized from the sale over the option price. This limitation doesn’t apply if a loss wouldn’t otherwise be deductible for the transfer, such as for a wash sale.
The IRS has made it clear in Treasury Regulation Section 1.422-1(b) that a Section 83(b) election is not effective for regular tax reporting for stock acquired by exercising an incentive stock option, but is effective for the alternative minimum tax. As a result, when an early exercise (before vesting) of an incentive stock option is allowed and done and there is a disqualified disposition of the stock, the fair market value for computing ordinary income and the holding period for the stock is determined based on the vesting date. Once the holding period requirements are met, the disposition is qualified and vesting is disregarded for the ISO stock for regular tax reporting.
The results can be confounding.
For example, Jane Employee makes an early exercise of an incentive stock option on January 1, 20X1 and makes a Section 83(b) election. The grant date is also January 1, 20X1. The fair market value of the stock is the same as the option price on the date of exercise. 20% of the grant vests one year after the grant date. Jane sells vested shares on January 2, 20X2, for a $100,000 gain. For regular tax reporting, Jane has $100,000 of ordinary income. For AMT reporting, Jane has $100,000 of long-term capital gain. Jane has realized no tax savings for this sale from making a Section 83(b) election.
For a second example, John Employee makes an early exercise of an incentive stock option on January 1, 20X1, but doesn’t make a Section 83(b) election. 20% of the grant vests one year after the grant date and 2% per month thereafter. John continues to hold the stock. There is no taxable income for the regular tax until the stock is sold or otherwise transferred in a nonqualifying transfer. For the AMT, John must report as ordinary income the excess of the fair market value over the option price for the vesting shares. For this example, let’s say that’s $100,000 for 20% of the shares on January 1, 20X2 and $10,000 per month for the rest of 20X2, for a total of $210,000. The $210,000 is added to the cost of the vested shares for AMT reporting when John eventually sells the shares. If John sells the shares after holding them more than two years after the grant date and more than one year after the date of exercise, all of his gain will be long-term capital gain for regular tax reporting. Some of his (smaller) gain may be short-term capital gain for AMT reporting, based on the holding period for the various blocks of stock as they vested.
As you can see, a Section 83(b) election can still be helpful to reduce or avoid the alternative minimum tax from future appreciation of the stock when an employee makes an early exercise of an ISO.
Remember, the ordinary income reported to compute the AMT is added to the tax basis (cost for computing gain and loss) on Schedule D for computing the AMT, but not for the regular tax. Also, under Internal Revenue Code Section 83(b), the ordinary income relating to the exercise of the option is lost as a tax deduction if the stock is forfeited, such as if the employee is terminated. This is a serious disadvantage of making the election that should be considered before going ahead with the election when the ordinary income is significant.
When the holding period requirements aren’t met and the stock sold at a gain is held more than a year after exercise, an employee would have been better off having a nonqualified stock option and making a Section 83(b) election at exercise.
April 18 will soon be here!
The tax deadline for individuals and calendar year estates and trusts to file their 2016 income tax returns and their first 2017 estimated tax payment is April 18, 2017.
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Financial Insider Weekly broadcast schedule for March and April.
Financial Insider Weekly is broadcast in San Jose and Campbell on Fridays at 9:30 p.m., Pacific Time. You can watch it on Comcast channel 15 for San Jose and Campbell. The show is broadcast as streaming video at the same time at www.creatvsj.org.
Here are the scheduled interviews for March and April:
- March 24 and 31, Martin Schainbaum, attorney at law, “I owe the IRS! Now what?”
- April 7 and 14, Janis Carney, attorney at law, Carney Elder Law, “The Elder Care Journey Part 1 of 3”
- April 21, Janis Carney, attorney at law, Carney Elder Law, “The Elder Care Journey Part 2 of 3”
- April 28, Janis Carney, attorney at law, Carney Elder Law, “The Elder Care Journey Part 3 of 3”
Financial Insider Weekly is also broadcast as follows:
- Sundays at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27.
- Sundays at 1 p.m. on Comcast channel 26 in Santa Cruz County and on Charter Communications Channel 72 in Watsonville and Capitola
- Sundays at 10:00 p.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27.
- Mondays at 1:30 p.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27
- Mondays at 6:30 p.m. on Midpeninsula Media Center, Comcast Channel 28 in Palo Alto, East Palo Alto, Stanford, Menlo Park & Atherton
- Mondays at 7:00 p.m. Pacific Time on cable channel 19 in Morgan Hill and broadcast on the internet at the same time as streaming video at www.mhat.tv
- Mondays at 7:30 p.m. on Comcast channel 15 in Saratoga
- Tuesdays at 2:30 a.m. and 12:30 p.m. on Midpeninsula Media Center, Comcast Channel 28 in Palo Alto, East Palo Alto, Stanford, Menlo Park & Atherton
- Tuesdays at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27.
- Tuesdays at 7:00 p.m. Pacific Time on cable channel 19 in Morgan Hill Broadcast on the internet at the same time as streaming video at www.mhat.tv
- Wednesdays at 8:00 p.m. on Comcast channel 28 in Hayward, Alameda and Fremont and on AT&T U-Verse Channel 99, Hayward public access TV 28 in California
- Thursdays at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27.
- Fridays at 11:00 a.m. on Comcast channel 26 in Santa Cruz County and on Charter Communications Channel 72 in Watsonville and Capitola.
- Fridays at 3:30 p.m. on KCAT, Comcast channel 15 in Los Gatos
- Fridays at 4:00 p.m. on KMTV cable channel 15 in Cupertino, Los Altos and Mountain View
- Fridays at 6:00 p.m. on Comcast and Astound channel 29 in San Francisco. Online streaming video at www.bavc.org, “public access TV”
- Fridays at 8:00 p.m. on Comcast channel 28 in Hayward, Alameda and Fremont and on AT&T U-Verse Channel 99, Hayward public access TV 28 in California
- Saturdays at 9:00 a.m. and 6:00 p.m. on Midpeninsula Media Center, Comcast Channel 28 in Palo Alto, East Palo Alto, Stanford, Menlo Park & Atherton
- Saturdays at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27.
- Saturdays at 1:00 p.m. on Comcast channel 26 and AT&T U-verse channel 99 in Marin County
Past episodes of Financial Insider Weekly are posted on YouTube. One way to watch them is to go to our web site, www.financialinsiderweekly.com, and click on "Past Episodes."
Let me know any ideas that you have for topics or guests. Guests will usually have to be located in or near the Silicon Valley in California.
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Michael Gray regrets he can no longer answer emails personally. He will answer selected questions in this newsletter. Email your questions to email@example.com.
See the books mentioned at www.employeestockoptionsecrets.com or the Special Report, Nonqualified Stock Options – Executive Tax and Financial Planning Strategies at www.stockoptionadvisors.com/non-q_stock.shtml.
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Consult with a tax advisor
For our readers who aren’t tax advisors, this newsletter is intended to alert you about tax issues that could affect you. It is not a substitute for advice from a professional tax advisor. You will find that getting advice from a qualified advisor is a worthwhile investment.
Tax advisors should view the newsletter as an alert to become aware of issues relating to employee stock options for further research and study.
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(Michael Gray is the author of Secrets of Tax Planning For Employee Stock Options, Stock Grants and ESOPs.)